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Chapter 4
Extensions of
Demand and
Supply Analysis

Copyright ©2014 Pearson Education, Inc. All rights reserved. 4-2
Introduction
In recent years, shoppers have experienced a type of
“sticker shock” when they find that prices of used cars
are only slightly lower than prices of new models.
You can use the concept of simultaneous shifts in
supply and demand to explain why we observe this
outcome in the vehicle market.
Chapter 4 will show you how to represent the effects of
a simultaneous change in supply and demand.

Learning Objectives
• Discuss the essential features of the price
system
• Evaluate the effects of changes in demand
and supply on the market price and
equilibrium quantity
• Understand the rationing function of prices

Learning Objectives (cont'd)
• Explain the effects of price ceilings
• Explain the effects of price floors
• Describe various types of government-
imposed quantity restrictions on markets

Chapter Outline
• The Price System and Markets
• Changes in Demand and Supply
• The Rationing Function of Prices
• The Policy of Government-Imposed Price
Controls
• The Policy of Controlling Rents
• Price Floors in Agriculture
• Price Floors in the Labor Market
• Quantity Restrictions

Did You Know That ...
• A coffee shortage exists in Venezuela?
• This country, with its traditionally high levels of
coffee production and consumption, now faces a
situation in which the quantity of coffee demanded
exceeds the quantity supplied.
• The shortage results from a price ceiling that
prevents the price from rising to its equilibrium
level.

The Price System and Markets
• Price System or Market System
– An economic system in which relative prices are
constantly changing to reflect changes in supply
and demand
• The prices are signals as to what is relatively scarce
and relatively abundant
• Prices provide information to individuals and
businesses

(cont'd)
• Voluntary Exchange
– An act of trading between individuals in the price
system
– Makes both parties to the trade subjectively
better off

(cont'd)
• Transaction Costs
– All of the costs associated with exchange
– Including:
• The informational costs of finding out the price and
quality, service record, and durability of a product
• The cost of contracting and enforcing that contract

(cont'd)
• The role of middlemen
– Middlemen (intermediaries) or brokers reduce
transaction costs by providing information to
buyers and sellers
– Examples
• Real estate brokers
• Stock brokers
• Consignment shops
• Car dealerships

Example: Linking Businesses to
Customers on the Go via QR Apps
• Many small businesses arrange for
customers to order products through QR
apps.
• For example, you might be able to use your
smartphone to order a cup of coffee before
you even arrive at the local coffee shop.
• The middlemen companies who provide
these QR apps facilitate the process of
linking firms with their customers.

Changes in Demand and Supply
• Changes in supply and demand create a
disequilibrium.
• The market price and quantity adjust to a
new equilibrium.

Figure 4-1 Shifts in Demand and in Supply:
Determinate Results, Panel (a)

Determinate Results, Panel (b)

Determinate Results, Panel (c)

Determinate Results, Panel (d)

(cont'd)
• Summary
– Increases in demand increase equilibrium price
and quantity
– Decreases in demand decrease equilibrium price
and quantity

(cont'd)
• Summary
– Increases in supply decrease equilibrium price
and increase equilibrium quantity
– Decreases in supply increase equilibrium price
and decrease equilibrium quantity

(cont'd)
• When both demand and supply change
– If both the supply and demand curves shift
simultaneously, the outcome is indeterminate
for either equilibrium price or equilibrium
quantity
– The resulting effect depends upon how much
each curve shifts

(cont'd)
• When both demand & supply increase
– Change in equilibrium price is indeterminate
– Equilibrium quantity increases unambiguously
• When both demand & supply decrease
– Change in equilibrium price is indeterminate
– Equilibrium quantity decreases unambiguously

(cont'd)
• When supply decreases & demand increases
– Equilibrium price increases
– The change in the equilibrium quantity is
uncertain without more information
• When supply increases & demand decreases
– Equilibrium price decreases
– The change in the equilibrium quantity is
uncertain without more information

International Example: What Accounts for the
Rising Price of Shipping Containers?
• We can identify several reasons for the
recent rise in prices of shipping containers.
– One reason is that many containers purchased
were originally purchased in 2001, and as they
have now reached the end of their useful life,
they must be replaced.
– This is illustrated by the graph on the next slide.

Figure 4-2 The Effects of a Simultaneous
Decrease in Shipping Container Supply and
Increase in Shipping Container Demand

International Example: What Accounts for the
Rising Price of Shipping Containers? (cont’d)
• There have also been decreases in the
supply of shipping containers.
– Many shipping containers were lost in the
tsunami of 2011.
– The price of steel, an important input for the
manufacture of shipping containers, has
increased by 7 percent.
• Taken together, these supply and demand
shifts have caused a higher equilibrium price
for shipping containers.

(cont'd)
Price Flexibility
• Prices quite flexible in some markets can be
less flexible in other market scenarios.
– May take the form of subtle adjustments such as
hidden payments, quality changes
– May not reach equilibrium right away

(cont'd)
• Adjustment speed
– Market characteristics influence adjustment
speed
– Markets may overshoot in the adjustment
process
– Markets are subject to energy shocks, labor
strikes, severe weather

The Rationing Function of Prices
• Synchronization of decisions of buyers and
sellers that leads to equilibrium is called the
rationing function of prices

(cont'd)
• Methods of non-price rationing
– Rationing by queues (waiting in line)
– Rationing by random assignment or coupons

Example: An Airline Boarding
Lottery
• Airline passengers have an incentive to take
more carry-on bags, now that fees are
charged for checked luggage.
• Under the traditional boarding procedure,
passengers at the rear of the plane board
first, and many of them tend to place their
carry-ons in compartments at the front of
the aircraft cabin.
• What problem has resulted from this
boarding arrangement?

Example: An Airline Boarding
Lottery (cont’d)
• The difficulty is that passengers in the front
of the plane often have to scramble to find a
free luggage compartment.
• American Airlines has circumvented this
problem by assigning boarding-group
numbers randomly, rather than by boarding
the rear of the plane first.
• This change has speeded up the boarding
process by several minutes.

(cont'd)
• The essential role of rationing
– Implied by the presence of scarcity
– Price vs. non-price rationing mechanism:
• Price rationing leads to the most efficient use of
available resources
• All gains from mutually beneficial trade are captured in
a freely rationing price system

The Policy of Government-Imposed
Price Controls
• Price Controls
– Government-mandated minimum or maximum
prices
• Price Ceiling
– A legal maximum price
• Price Floor
– A legal minimum price

Price Controls (cont'd)
• Price ceiling and black markets
– A price ceiling may prevent the equilibrium price
from being achieved if it is above the ceiling
price
– A price ceiling that is set below the market
clearing price creates a shortage

Price Controls (cont'd)
• Non-Price Rationing Devices
– All methods used to ration scarce goods that are
price-controlled
• Black Market
– A market in which price-controlled goods are
sold at an illegally high price

Figure 4-3 Black Markets for Portable Electric
Generators

International Policy Example: Multiple Price
Ceilings Lead to Electricity Rationing in China
• In China, two key sources of electricity are coal
and diesel fuel used to power generators.
• However, both of these items are subject to price
ceilings.
• There are also price ceilings imposed on electricity
provided by power companies.
• As a consequence, much of China experiences
“brownouts” when the flow of electricity is reduced.

The Policy of Controlling Rents
• The functions of rental prices
1. Promote the efficient maintenance and
construction of housing
2. Allocate existing housing
3. Ration the use of housing

(cont'd)
• Rent controls and construction
– Controls discourage construction
• With a 16% vacancy rate and no controls, Dallas
recently built 11,000 new rental units
• With a 1.6% vacancy rate and controls, San Francisco
recently built 2,000 new rental units

(cont'd)
• Effects on the existing supply of housing
and current use of housing
– Property owners cannot recover costs
• Maintenance, repairs, capital improvements
– Rations the current use of housing
• Reduces mobility, e.g., New York’s “housing gridlock”

(cont'd)
• Attempts to evade rent controls
– Forcing tenants to leave
– Tenants subletting apartments
– Housing courts

(cont'd)
• Who wins and who
loses from rent controls?
– Losers
• Property owners
• Low-income individuals
– Winners
• Upper-income professionals

Price Floors in Agriculture
• Support Price
– The government chooses a price floor for a
product and then acts to ensure that the price of
the product never falls below the support level
• Associated with many agricultural products
• A price floor that is set above the market clearing price
results in a surplus.

Figure 4-4 Agricultural Price Supports

Price Floors in Agriculture (cont'd)
• Questions
– How could the government keep the price from
falling?
– Who benefits from agricultural price supports?

What If . . . the government decides to “help dairy
farmers” by imposing a price floor in the market for milk
that is above the equilibrium price?
• A price floor imposed above the equilibrium
price would lead to an increase in the
quantity of milk supplied and a decrease in
the quantity demanded.
• To maintain the price floor, the government
would have to purchase the surplus of milk.
• Indeed, dairy farmers would benefit, but
consumers would end up paying higher
prices for milk.

Price Floors in the Labor Market
• Minimum Wage
– A wage floor, legislated by government, setting
the lowest hourly wage rate that firms may
legally pay their workers

Figure 4-5 The Effect of Minimum
Wages

Policy Example: A Higher Minimum Wage
Translates into Fewer Employed Teens
• The federal minimum wage was increased
in three steps from $5.15 to $7.25 per hour
between 2007 and 2009.
• This legislation had little effect in 18 states
where market wages already exceeded
$7.25 per hour.
• In the other 32 states, however, the wage
increases caused a drop of 114,000 in the
total number of teenagers employed.

Quantity Restrictions
• Governments can impose quantity
restrictions, most obvious—banning
ownership or trading of a good
– Human organs
– Drugs
– Hospital beds
– Gold from 1933 to 1973

Quantity Restrictions (cont'd)
• Government Prohibitions and Licensing
Requirements
– Some commodities cannot be purchased at all
legally; others require a license
• Import Quota
– Supply restriction that prohibits the importation
of more than a specified quantity of a particular
good

You Are There: Explaining the “Crisis” of
Persistent Drug Shortages
• Today, the FDA has identified shortages of
more than 200 drugs.
• Some have suggested that the persistent
shortages are the result of government
price restrictions.
• The FDA limits the amount by which the
price of any drug can increase in a given
year.
• This may result in some prices being below
the market-clearing level.

Issues & Applications: Why Prices of
Used Cars Are So High
• Since 2009, the average price of a used car
has increased by nearly 10 percent.
• Simultaneous changes in supply and
demand account for this price change.
• The supply of used cars has decreased due
to the “cash for clunkers” program.
• You can see this illustrated in the graph on
the next slide.

Figure 4-6: The Effects of a Decrease in the Supply of
Used Cars in Conjunction With an Increase in the
Demand for Used Cars

Issues & Applications: Why Prices of
Used Cars Are So High (cont’d)
• Also, the supply of new cars decreased due
to the earthquake and tsunami in Japan.
• This decreased supply led to a higher price
of new cars, and therefore the demand for
used cars (a substitute good) also
increased.
• Taken together, the decreased supply and
increased demand have caused a higher
equilibrium price of used cars.

Summary Discussion of Learning
Objectives
• Essential features of the price system
– A price system (market system) allows prices to
respond to changes in supply and demand for
different commodities
– Prices are communicated in markets that tend to
minimize transactions costs

Objectives (cont'd)
• How changes in demand and supply affect
market price and equilibrium quantity
– Increases in demand increase equilibrium price
and quantity; decreases in demand decrease
equilibrium price and quantity
– Increases in supply decrease market price and
increase equilibrium quantity; decreases in
supply increase market price and decrease
equilibrium quantity

Objectives (cont'd)
• How changes in demand and supply affect
equilibrium price and equilibrium quantity
– When both demand and supply shift at the same
time, the outcome is indeterminate for either
equilibrium price or equilibrium quantity

Objectives (cont'd)
• The rationing function of prices
– In a market system, prices ration scarce goods
and services
– Other ways of rationing include first come, first
served; political power; physical force; random
assignment; and coupons

Objectives (cont'd)
• The effects of price ceilings
– A price ceiling set below the market clearing
price results in a shortage
• The resulting shortage can lead to non-price rationing
devices and black markets

Objectives (cont'd)
• The effects of price floors
– If the price floor is set above the market clearing
price, a surplus results
• A price floor can take the form of a government-
imposed price support or minimum wage

Objectives (cont'd)
• Government-imposed restrictions on market
quantities
– Bans on sale or ownership
– Licensing restrictions
– Import quotas

Appendix B: Consumer Surplus
• Consumer Surplus
– The difference between the total amount that
consumers would have been willing to pay for an
item and the total amount that they actually pay

Figure B-1 Consumer Surplus

Appendix B: Producer Surplus
• Producer Surplus
– The difference between the total amount that
producers actually receive for an item and the
total amount that they would have been willing
to accept for supplying that item

Figure B-2 Producer Surplus

Appendix B: Gains from Trade within a Price
System
• Gains from trade
– The sum of consumer surplus and producer
surplus

Figure B-3 Consumer Surplus, Producer
Surplus, and Gains from Trade

Appendix B: Price Controls and Gains from
Trade
• How do price controls affect gains from
trade?
– Consumer surplus and producer surplus are both
lower
– Either a price ceiling or a price floor reduces
gains from trade

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